The root cause of the troubles that mortgage giants Fannie Mae, Freddie Mac and Ginnie Mae experienced during the financial crisis can be found in the conflicting mandates of their business models, the former head of Fannie Mae told a congressional commission on Friday.
"I accept responsibility for everything that happened on my watch," said Daniel Mudd (pictured), former president and chief executive officer of Fannie Mae, who testified before the Financial Crisis Inquiry Commission. But he said the demands put on Fannie Mae to support affordable housing and home ownership ultimately made it impossible for the organization to succeed in its other mission: making a profit.
During the crisis of 2007 and 2008, "so many decisions were a choice between unsavory alternatives," Mudd said. "I could not do what a private firm could do: leave the market, close the window, or short mortgages." Under the mandate Congress gave them when they were created, the three government-sponsored enterprises (GSEs) that underpin the U.S. mortgage system must stay in the market and provide liquidity.
Without revenue, profits and growth, the company could not attract global capital to the U.S. housing market. On the other hand, the GSE also had to meet the mission goals for affordable housing and liquidity that were written into its congressional charter, Mudd said.
"A monoline GSE asked to perform multiple tasks [could] not withstand a multiyear 30% home price decline on a national scale, even had it been without the accompanying global financial turmoil," Mudd said. Unlike other financial institutions, the GSEs were unable to diversify, and the housing market collapse of 2007-2010 made it impossible for them to operate profitably.
Operating in Havoc
In 2008, the Federal Housing Finance Agency put Fannie Mae and Freddie Mac into conservatorship. At the time, the two owned or guaranteed nearly 57% of the $12 trillion U.S. mortgage market.
But even as late as as the end of 2008, the Office of Federal Housing Enterprise Oversight, Fannie Mae's regulator, declared that the GSEs were in full compliance with their capital requirements, Mudd said. As havoc developed in the housing markets, the GSEs were called on to refinance subprime borrowers and provide the lead in mortgage modifications. At the same, time Fannie Mae and Freddie Mac were pushed to raise capital, earn returns and cut costs.
"I sought to balance the fine points of mission and business, insofar as I could understand them, with the support of regulators and policymakers," Mudd said. "That was no longer possible by Sept. 6, 2008, and I am sorry for that." The demands of operating an enterprise sponsored by the government increasingly conflicted, he said.
There was overinvestment in housing, origination standards slipped and there were too many middlemen. "Home ownership rates probably rose too high," Mudd said.
"The fundamental and solid economics of home ownership will reassert themselves" once this crisis is behind the country, Mudd said. But without a consensus on national policy to support housing, he said, "It will be difficult to choose between competitive models for a new housing finance system. Government entities created to support home ownership as a social good will tend to socialize the risk to all taxpayers. Purely private companies will exercise their fiduciary responsibility to pass the costs and the risks to homeowners. Hybrid organizations, such as a GSE, will be left to balance conflicts between taxpayers and homeowners and shareholders. There are no simple answers."
To Stay Competitive, Fannie Bought Into Subprimes
Fannie Mae reported about $134 billion in net losses in 2008 and 2009, most of which came from loan losses and credit losses, Financial Crisis Inquiry Commission Chairman Phil Angelides said, citing the company's financial report. A significant amount of the approximately $104 billion in loan losses came from higher-risk products, such as "Alt A," subprime and interest-only loans, and loans to people with poor credit, originated in 2006 and 2007.
Angelides asked why Fannie Mae decided to invest in the higher-risk products in that period. Loans with high-risk features made in 2007 made up 29% of Fannie Mae's loans but accounted for 58% of the losses, 28% of the loans in 2008 but 75% of the losses, and 24% of 2009 loans but 69% of losses, he said.
Those higher-risk loans put on the books shortly before the housing market collapsed were, unsurprisingly, the worst-performing and were the first to go, Mudd said.
Fannie Mae had come out of a period during the 1990s when it was a dominant force in the marketplace. But that position had slipped as Wall Street and the private market developed competing products.
There was a "broad concern that under the continuation of these trends, Fannie Mae and by derivation Freddie Mac's role in the market would be less relevant." In response, Fannie Mae developed a plan to buy some of the new securities, he said.
Losing Influence to Private Companies
Robert Levin, former executive vice president and chief business officer of Fannie Mae, also testified that the growth of the private-label mortgage securities market, which primarily financed subprime mortgages, Alt A mortgages and jumbo loans, had a significant impact on both the mortgage markets as a whole and Fannie Mae in particular. "When Fannie Mae was one of the principal sources of capital in the mortgage market, Fannie Mae's influence was greater. When other sources of capital were more plentiful, as in the period prior to the crisis, Fannie Mae's influence was diminished," he said.
In 2003, the amount of private-label securities issued was about half that of Fannie Mae's, but in 2004, dollar volumes of private-label securities increased dramatically, exceeding the levels of Fannie Mae's mortgage-backed securities, and almost reaching the levels of Fannie Mae and Freddie Mac combined. The trend continued in 2005 and 2006, when the dollar volume of private-label securities issued exceeded the combined dollar volume of mortgage-backed securities issued by Fannie Mae, Freddie Mac and Ginnie Mae.
Fannie Mae's business activity relative to the overall market declined significantly during that time. Many of the products funded by private-label issuers had features that attracted low-income borrowers, which threatened Fannie Mae's ability to meet its mandated housing goals, Levin said. "Fannie Mae had never previously experienced market changes of the magnitude that we were seeing during this period," he said.
In response, Fannie Mae expanded its Alt A business "incrementally over time," he said. But he added that Fannie Mae applied underwriting standards that were more conservative than those prevalent in the market at the time. Fannie Mae's Alt A mortgage business, while responsible for a disproportionate amount of the company's losses, did perform better than the market, and it sustained smaller losses than otherwise might have occurred, he said.
Fannie Mae's involvement in the subprime market was "minimal," he said, consisting primarily of purchasing AAA-rated private-label securities backed by subprime loans, which contributed to its housing goal objectives. "With the benefit of hindsight, had we anticipated the extraordinary market meltdown, we would have been far less likely to expand our involvement in these non-traditional products," he said.
Fannie Mae began to reduce its participation in the Alt A market in 2007, when the market took a turn for the worse, Levin said. But at that point, it was too late. "An unprecedented decline in home prices, a high unemployment rate, a global liquidity and credit crisis, engulfed Fannie Mae and its only line of business, a secondary market for mortgages. These crises were centered on our market and our asset class, and we took the full brunt of the market crisis head on, which would have been difficult for the company to deal with under any circumstances."
Bonds for Beginners
Learn about fixed income investments.View Course »